In economics, when an individual’s income increases, the marginal propensity to save (MPS) determines the amount of money saved instead of spent on goods and services. MPS is an element of Keynesian Economic Theory, which helps economists determine how to spend government dollars or private funding. But what does MPS mean to the average household’s savings? This article will explain how to calculate MPS, why it matters, and what it means to you.
The Keynesian Economic Theory, Explained
Economist John Maynard Keynes published The General Theory of Employment, Interest, and Money, or simply as The General Theory, in 1936. This text changed economic thought from that point on and is known as one of the classic economic publications. In the book, Keynes tried to explain economic fluctuations, especially the ones seen in the Great Depression of the 1930s.
Essentially, The General Theory was built on the idea that as a result of inadequate demand for goods and services, recessions and depressions could occur. Keynes’ theory was not just for economists—it was intended for policymakers worldwide. Keynes advocated for an increase in government spending, which would boost the production of goods and services to minimize unemployment rates and enhance economic activity. In general, this theory went against the traditional economic policy of laissez-faire, which requires minimal government involvement.
There are three main elements of this theory. These elements include:
• Aggregate demand: This is the demand influenced by the public and private sectors. The level of demand in the private sector may impact macroeconomic conditions. For instance, a lull in spending may bring an economy into a recession. At this point, the government can intervene with monetary stimulus.
• Prices: Wages, for example, are often slow to respond to supply and demand changes. This may result in an excess or shortage of labor supply.
• Changes in demand: Any change in aggregate demand results in the most considerable impact on economic production and employment. The theory states that consumer and government spending, investments, and exports increase output. Therefore, even a change to one of these factors and the output will change.
The Keynesian Multiplier was created as a result of the change in aggregate demand. The Keynesian Multiplier states , “The economy’s output is a multiple of the increase or decrease in spending. If the fiscal multiplier is greater than 1, then a $1 increase in spending will increase the total output by a value greater than $1.”
How to Calculate Marginal Propensity to Save and Consume
The Keynesian Multiplier value relies on the marginal propensity to save (MPS) and the marginal propensity to consume (MPC).
Marginal Propensity to Save
When people receive additional income, the MPS is the change in the savings amount. If their income increases, the MPS measures the amount of income they choose to save instead of spending it on goods and services.
That said, the MPS is calculated as MPS = change in savings / change in income.
For example, let’s say someone received a $1,000 raise. Of that $1000 increase in income, they decide to spend $300 on new clothes, $200 on a fancy dinner out, and save the remaining $500, so the MPS is 0.5.
(1000 – 300 – 200) / 500 = 0.5
Marginal Propensity to Consume
Conversely, the MPC is the change in the spending, or consuming, amount. If someone’s income increases, the MPC measures the amount of income they choose to spend on goods and services instead of savings.
With this in mind, MPC is calculated as MPC = change in consumption / change in income.
By using the example above, the MPC would be 500 / 1000 = 0.5.
Factors That Influence Saving and Consumption
The MPS and MPC seem pretty straightforward. However, both calculations only account for the excess of disposable income; the calculations don’t account for other factors that may influence a consumer’s consumption functions. If one of these non-income factors shifts, the entire consumption function may shift. Here are some of the non-income factors that may influence a consumer’s consumption function.
Wealth and income are two different variables in economics. For example, suppose Javier has a job earning $60,000 per year. If his aunt Ines passes away and leaves him $200,000 as an inheritance, his income is still $60,000 per year, but his wealth has increased. Similarly, if Javier owns a piece of art that increases in value or his investment portfolio grows, his wealth has also gone up. Just because his wealth increases doesn’t mean his income does as well.
Therefore, an increase in wealth may increase consumption despite income levels staying the same. However, both the consumption and savings function may shift upwards as well because of the newfound wealth. The same is true in the opposite situation. If wealth decreases, the consumption and savings functions may decrease as well.
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In some cases, consumers may adjust their spending habits based on the expectation of future income coming their way. Expectations change the shift in consumption and savings functions because there is no change in actual income, just how it’s being spent.
For example, suppose Naomi assumes her income is going to increase soon. She may consume more now because of her expectation that her income is about to grow. This may highlight an upward shift in the consumption function without an increase in income.
On the other hand, if Naomi were pessimistic about her future income, such as the fear of losing her job, she may decrease her consumption without dropping her income. This scenario may also shift the consumption factor.
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Consumers may also adjust their consumption and savings if they’re in debt. It’s observed that in economies where consumer debt rises, savings go up while consumption goes down. There is a level of debt when consumers typically feel uncomfortable spending more. Even if their income remains the same, if too much debt plagues their pocketbooks, they will start to save more and spend less so they can pay off their debt.
Conversely, if there are low levels of debt, consumers tend to spend more and save less.
Why Marginal Propensity to Save Matters
Using the data from MPS and MPC helps businesses, governments, and foreign policymakers determine how funds are allocated. For example, economists can assess this data to determine increases in government spending or investment spending, influencing savings numbers.
As for consumers, using the marginal propensity to save formula can help them make adjustments to their own spending habits. If their MPC is higher than their MPS, adjustments to consumption may need to be made.
How to Start Saving Money
While the way consumers spend helps the government and economists determine the best way to increase government spending, the way you choose to spend your money can help you set up a solid financial future. Carefully considering all of your spending options may get you on a path toward financial security.
So if a windfall comes your way, you may want to consider carefully choosing how to spend those funds. While it’s tempting to use the money on a shopping spree, putting it in some type of savings account may be a better financial decision. After all, saving your extra disposable income can help build a rainy day fund for emergency expenses, help you stay away from debt, and accumulate a nest egg for your retirement.
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Here are a few steps for getting started:
Identifying Your Savings Goals
Do you have short-term goals like accumulating an emergency fund to pay for unexpected expenses? Or perhaps you want to save for a family vacation? Maybe you have a medium-term goal, such as paying for a wedding reception or a new kitchen renovation. Or would you like to save for retirement as a long-term goal? No matter your goals, you’ll want to have a clear idea of how much cash you need and by when.
First, decide on a goal date—when you want to have the money save by. Then, divide the goal amount by the time frame, in months, to determine how much cash you need to stash away each month. Finally, decide where to keep the funds.
• If your goal is short-term, you may want to consider putting your cash in a high-yield savings account or money market account. Either type of account is relatively low risk and is likely to be FDIC or NCUA insured, depending on the financial institution.
• If the goals are more long-term, retirement accounts or brokerage accounts are worth considering since they may help your money grow.
Creating a Budget
It’s hard to keep track of your money if you don’t know where it’s going. Creating and sticking to a budget is a great way to monitor your spending habits so you can stay on track.
To start, take note of your expenses for a month or two. Next, create a monthly budget that reflects the average spending amounts for fixed expenses such as your mortgage and variable expenses such as eating out or clothes shopping. If you determine you’re spending more than you earn, you may want to look for ways to cut back on your expenses, such as canceling subscriptions you don’t use.
Using a tool like SoFi Relay makes it easy to track and categorize your expenses. It also helps you find ways to save and lets you monitor your progress toward your goals.
When you receive an increase in your income, setting up automatic contributions to your savings or retirement accounts allows you to set aside extra money by automating your savings instead of having to manually transfer money each month.
SoFi Money® is a cash management account worth considering when looking for a savings vehicle. It can help you spend, save, and earn all in one place. Set goals and save for them using the account’s automated savings features, all without paying any account fees.
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